Abstract
Since the 1990s, the SEC has advocated for financial disclosures to be in “plain English” so that they would be more readable and informative. Past research has shown that high readability is related to more extreme investor judgments of firm performance. Processing fluency is the prevalent theory to explain this: higher readability increases the investor’s subconscious reliance on the disclosure, so positive (negative) news leads to more positive (negative) judgments. The relationship may not be so simple, though: drawing on research from cognitive psychology, I predict and find that investor financial literacy simultaneously influences investor decision-making, and that it has an interactive effect with readability. When presented with financial disclosure containing conflicting financial information, investors with higher financial literacy make more negative judgments than investors with low financial literacy when the disclosure is easy to read, but the effect becomes insignificant when the disclosure becomes difficult to read. This effect is moderated by a comprehension gap between the two investor groups. Financial literacy and readability interact to impact both how and how well the investor processes financial information.
Highlights
In order to address concerns about disclosure readability, the SEC’s Plain English Rule 421(d) went into effect in 1998 and requires that plain English principles be followed in firm prospectuses, ostensibly to encourage companies to better communicate and build relationships with investors because plain English is how individuals naturally process information
Miller [3] focuses on small investors—those trading below $5000—and finds that high readability in 10-K disclosures is associated with greater trading volume, while low readability in these disclosures reduces consensus in small investors but not in large investors
Miller [3] finds that retail investors are especially influenced by the readability of disclosures, and the SEC emphasizes that its plain English recommendations are meant to help the “least-sophisticated investors” [7] — retail investors are an appropriate population for study in this experiment
Summary
My results contribute to existing literature by identifying financial literacy as a factor that interacts with readability to influence financial judgment, and by further decomposing the readability effect by identifying the differing pathways by which readability exerts its influence on less sophisticated and more sophisticated investors These are, perhaps not the results that the SEC might have hoped for: while readability absolutely does influence investors’ judgments, it appears that it does so almost solely through more sophisticated investors—meaning that the “least-sophisticated” investors who are most at risk for getting bamboozled by verbal calisthenics appear to not get as much as could be hoped for out of financial disclosures written in plain English.
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